Should You Let Employees Borrow Money From Their Retirement Accounts?

Due to the challenges of making ends meet in today’s economy, there has been a dramatic increase in the amount of loans taken out of retirement plans by participants in need of funds to “bridge the gap”. I am often asked by plan sponsors, how participant loan requests should be handled and whether it is appropriate for the plan sponsor to attempt to counsel participants before signing off on loan distribution requests.

Whether a plan allows for participant loans is a philosophical question – should people be permitted to borrow from their future?

One the on hand, some would say things such as “Why not? Borrowing from the future is the American way!” and “People should have access to the money in their accounts and not have to obtain permission from “mom and dad.” As an interesting aside, during the 2008 calendar year, participants with significant loan balances were the only ones with positive (or less negative) investment returns as their interest paid was allocated directly to their account and helped to buffer the tumultuous results of the 2008 financial markets – I have since heard this argument used to bolster the case of more readily allowing participant loans within retirement plans.

On the other hand there are hidden costs to borrowing from the plan, including lost earnings on investment balances and the potential of having the loan treated as a distribution (subject to income taxes and a 10% early withdrawal penalty) if the participant is no longer employed by the plan sponsor and cannot immediately pay back the outstanding loan balance.

I would like to think that in general, people are responsible and can make informed decisions, however I continue to be amazed at how many people are caught off guard by the fact that when they discontinue their employment, they receive a Form 1099-R and must pay income taxes and an early withdrawal penalty on the unpaid balance of the loan. Too often, the funds are not available to pay such taxes and the participant takes a cash distribution of the remaining plan balance in order to pay the taxes, which is also subject to tax and early withdrawal penalties, and so the vicious cycle begins.

I must say that personally, I am not in favor of allowing loan provisions within a qualified retirement plan for two reasons. First and foremost, money funding these accounts is for retirement and should not be perceived as a rainy day fund to be used whenever needed – if participants have a dire need, they can access the funds via a hardship withdrawal for specific purposes. Second, participant loans will increase the administrative cost of operating a retirement plan, both in the workload of plan sponsor personnel and in the costs paid to service providers (including third party administrators and plan auditors) to reconcile the loan balances annually.

My recommendation is for plan sponsors who offer loan provisions within their plans to counsel participants interested in borrowing funds from their account balance so that they understand the how the loan will work, the possibility for reduced investment returns since the funds will no longer be invested in the market and the potential for the unpaid balance to be treated as a taxable distribution if they terminate employment. Some investment advisory firms are willing to provide this service along with the investment education they provide to participants of the plan and this alleviates the burden to the plan sponsor of having a financial discussion with an employee.